Template:Financialisation of the markets

Bear in mind the broad sweep of three historical trends that converged in the 1980s.

Financialisation

First, the rapid onset of financialisation of, well, everything, due to parallel developments in information technology. Through the Seventies and Eighties, Western markets acquired the mental habits and technical systems needed to look at financial risk in a much more detailed, segmentable, way, as substrate-neutral derivatives of real-world propositions. Financial instruments were traded electronically. Increasingly, institutions modelled their risk with computers. They unbundled big, organic, ineffable risks into discrete tradable components: first, between market risk and credit risk. Then more estoteric measures: volatility. Liquidity. Convexity. Correlation. Credit and debt value.

At the same time, the market developed the legal and contractual tools to implement this new way of thinking about risks. Principle among them was a new class of bilateral financial contracts unlike anything bank regulators had seen before, in which the usual master-slave relationships between creditors and debtors and between bankers and their customers were — apparently — moot. There was no lender or borrower. The parties were equals: traders.

The ISDA Master Agreement was at the vanguard of these new bilateral contracts.

At the same time, powered by the same irrepressible forces of modernity, the market internationalised. Reducing financial instruments to electronic impulses made cross-border trade easier. While central banks could manage prudential supervision in their own jurisdictions, it was increasingly difficult for them to do so across global financial markets where different regulatory regimes presented all kinds of arbitrage opportunities.

New capital regulation

These developments in banking and market technology called for a more sophisticated framework for managing institutional risk in the global markets. Banks were increasingly interconnected, both across exchanges and in private over-the-counter markets, and the speed at which they traded instruments and values changed meant there was heightened systemic risk should major institutions get into trouble. Even minor participants could have a disproportionate effect on system stability. We saw this with Long Term Capital Management.

At the same time the innovative financial instruments, which tended to be leveraged and shared few of the characteristics of traditional financial instruments, meant effective capital ratios at financial institutions declined over the 1980s. It became apparent that the worst-case loss scenario for a master trading agreement like the ISDA was orders of magnitude greater than that presented by exposure to, for example, a syndicated loan. As a result, the Basel Committee on Banking Supervision introduced harmonised global standards for the capital treatment of financial instruments including the new master trading agreements. These rules, now known as Basel I, were first published in 1986.

Corporate resolution didn’t change

While there was a good deal of harmony in the international capital markets, many domestic bankruptcy regimes — which were targeted at small and medium-sized enterprises and typically did not have such an international focus — did not similarly change or update.

Swaps remained an arcane part of the international capital markets. They were not relevant to the SMEs. Companies regulators, assignees and administrators did not well understand them, or how they worked. Having local tax and employment liabilities and “trade credit” arrangements in mind, Bankruptcy regimes tended to confer broad discretions on receivers and liquidators to ensure fair outcomes for all claimants upon a company’s resolution.

But broad discretion means lack of certainty. Especially for highly unusual arrangements like master trading agreements, which were not by nature creditor-debtor arrangements. Should an administrator try to “cherry-pick” the valuable Transactions in a swap portfolio while setting aside loss-making ones, the implications for bank counterparties — who had only entered into them on the assumption that they would all net out to a single exposure — could be far worse, and far more volatile, than the corresponding risks presented by an ordinary corporate loan or contractual claim.

Basel I addressed this “local insolvency risk” for derivatives by requiring swap dealers to obtain reasoned legal opinions that, under local bankruptcy rules, their master agreements could not be cherry-picked in this way. that the “single agreement” concept would work, and their rights to apply close-out netting would be respected.

And this is where the phase transition into bankruptcy becomes important. Typically, while a company is still solvent and is trading in the ordinary course, its master trading agreements may be enforced according to their terms in the ordinary course. It is only at the point of formal bankruptcy that the phantom shenanigans of wide-ranging equitable discretion hove into view. In some jurisdictions, the point at which everything changes is a split second, and getting the right side of it makes all the difference.